TYPES OF BANK #
Commercial banks:- Includes retail bank (which serves individual and small business & wholesale bank (serves corporate and institutional customer) . Mainly involved in deposits & loans.
Investment Banks:- Assists in raising capital and advising them on corporate finance matters such as mergers and restructuring.
Based on regulations of the region of business bank can do both business or only one business.
MAJOR RISKS #
CREDIT RISK:- Default by borrower or counterparty. Measured as loan losses as % of its assets.
MARKET RISK :- Losses from trading activity such as decline in value of investments.
OPERATIONAL RISK:- Losses arising from external events or failures on internal control.
Key measure of capital adequacy is Equity capital to asset ratio.
Tire 1 capital:- Equity capital
Tire 2 capital:- Long Term Debt
Regulatory Capital determined by bank regulators. Bank must maintain Amount stated in regulatory capital.
Economic Capital :- capital as per risk models. i.e. to cover banks risk.
MORAL HAZARDS (IMP) #
DEPOSITE INSURANCE:- Depositors funds are guaranteed up to some maximum amount if a bank fails. Insurance premium paid by banks. Insurance brings element of moral hazard.
Moral Hazard:- insured parties take greater risk than they would take without insurance.
This results in banks pay less attention to there financial health and offers higher rate on deposits and make higher risky loans with those deposits.
POTENTIAL CONFLICT OF INTEREST #
Due to business structure of bank or their holding company faces several conflict of interests. Investment bank division trying to sell newly issued stock might want the securities division to sell these divisions to sell that stock to their clients. Commercial bank might acquire non public information about the company when negotiating a loan or arranging a securities issuance. If trading desk gets this information, may benefit unfairly.
Chinese Wall:- is internal control to prevent information from being shared among these units.
INVESTMENT BANKING (IMP) #
PRIVATE PLACEMENT:- Securities are sold directly to qualified investor with substantial wealth and investment knowledge. Investment bank earns fees for arranging private placement.
PUBLIC OFFERING:- when issue is sold to public at large. Firm Commitment is when bank first buys entire issue at agreed price from the issuer and bank and then sells to public at higher price. Best effort is when bank is buying issue only to the extent of bank is able to sell it to public in this bank is do not have any obligation of buying unsold portion.
Initial public offerings IPOs :- When any firm issues stock for first time, that “first time” issue is IPO. Investment bank assists in determining IPO price, discover path through Dutch auction process.
BANKING BOOK VS TRADING BOOK #
BANKING BOOK refers to loans made, which are primary assets of commercial banks. Value of loan includes principal amount to be repaid and accrued interest on loan. Non Performing Loans (Payment overdue> 90 days) does not include accrued interest. A bank will recognize a loss on a loan f it becomes likely that the borrower will not fully repay the principal. Banks financial statements reflect a reserve for loan losses that is determined by management, against which actual loan losses are charged. Increases or decreases in the loan losses reserve are a potential tool for earning manipulations such as smoothing across business cycles by banks management. Trading book refers to assets and liabilities related to bank’s trading activities and Mark to market daily.
THE ORIGINATE – TO – DISTRIBUTE MODEL #
This model involves making loans and selling them to other parties. Eg. GNMA, FNMA, and FHLMC purchase mortgage loans from banks and issue securities backed by the cash flows from these mortgages
- Increases liquidity in lending market
- in addition to residential mortgage market this mode also excels in other areas such as student loan, credit card balances, commercial loans and mortgages.
This topic is covered in detail in subject one Foundations of risk management.
Basel Committee Regulations : Started as a regulation for capital requirement of credit risk using standardized models or internal models developed by firm. After crisis of 2007, Basel reduced use of internal models. After credit crisis two new liquidity ratio requirements 1) Liquidity coverage ratio (LCR) is meant to ensure that banks have enough funding sources to remain viable for 30 days in the event of minor financial stress and 2)Net Stable funding ratio.